LEVEL 8 SYSTEMS INC - 10-Q Quarterly Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark one)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004.

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from __________ to __________

Commission File Number 0-26392

LEVEL 8 SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

Delaware 11-2920559
- --------------------------------------------------------------------------------
(State or other jurisdiction of (I.R.S Employer Identification Number)
incorporation or organization)

214 Carnegie Center, Suite 303, Princeton, New Jersey 08540
----------------------------------------------------------------
(Address of principal executive offices) (Zip Code)

(609) 987-9001
----------------------------------------------------
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15d of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. YES _X_ NO ___

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES ___ NO _X_
-

Indicate the number of shares outstanding in each of the issuer's classes of
common stock, as of the latest practicable date.

37,168,245 common shares, $.001 par value, were outstanding as of August 10,
2004.

Page 1

LEVEL 8 SYSTEMS, INC.
INDEX

PART I. Financial Information Page
Number
------
Item 1. Financial Statements

Consolidated balance sheets as of June 30, 2004
(unaudited) and December 31, 2003 3

Consolidated statements of operations for the three
months and six months ended June 30, 2004 and 2003
(unaudited) 4

Consolidated statements of cash flows for the six months
ended June 30, 2004 and 2003 (unaudited) 5

Consolidated statements of comprehensive loss for the
three months and six months ended June 30, 2004 and
2003 (unaudited) 6

Notes to consolidated financial statements (unaudited) 7

Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 16

Item 3. Quantitative and Qualitative Disclosures about Market
Risk 23

Item 4. Controls and Procedures 23

PART II. Other Information 23

SIGNATURES 26

Page 2

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

LEVEL 8 SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)

JUNE 30, DECEMBER 31,
2004 2003
--------- ---------

ASSETS
Current assets:
Cash and cash equivalents ....................................... $ 29 $ 19
Cash held in escrow ............................................. 777 776
Assets of operations to be abandoned ............................ 136 149
Trade accounts receivable, net .................................. 43 12
Prepaid expenses and other current assets ....................... 64 270
--------- ---------
Total current assets ............................... 1,049 1,226
Property and equipment, net ..................................... 21 26
Software product technology, net ................................ -- 4,063
Other assets .................................................... 47 47
--------- ---------
Total assets ....................................... $ 1,117 $ 5,362
========= =========

LIABILITIES AND STOCKHOLDERS' EQUITY(DEFICIT)
Current liabilities:
Short-term debt ................................................. $ 3,145 $ 2,625
Accounts payable ................................................ 2,405 2,545
Accrued expenses:
Salaries, wages, and related items ........................... 797 508
Other ........................................................ 1,804 1,613
Liabilities of operations to be abandoned ....................... 482 451
Deferred revenue ................................................ 251 39
--------- ---------
Total current liabilities .......................... 8,884 7,781
Long-term debt .................................................. 185 131
Warrant liability ............................................... -- 198
Senior convertible redeemable preferred stock ................... 2,692 3,355
Stockholders' equity (deficit):
Preferred Stock ............................................ -- --
Common Stock ............................................... 36 27
Additional paid-in-capital ................................. 209,025 206,149
Accumulated other comprehensive loss ....................... (2) (6)
Accumulated deficit ........................................ (219,703) (212,273)
--------- ---------
Total stockholders' equity (deficit) ............... (10,644) (6,103)
--------- ---------
Total liabilities and stockholders' equity (deficit) $ 1,117 $ 5,362
========= =========

The accompanying notes are an integral part of the consolidated financial
statements.

Page 3

LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share amounts)
(unaudited)

THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2004 2003 2004 2003
-------- -------- -------- --------

Revenue:
Software ......................................................... $ 98 $ 43 $ 108 $ 79
Maintenance ...................................................... 73 84 146 167
Services ......................................................... 79 50 79 74
-------- -------- -------- --------
Total operating revenue .................................... 250 177 333 320

Cost of revenue:
Software ......................................................... 3,689 845 4,408 1,682
Maintenance ...................................................... 94 103 198 195
Services ......................................................... 286 197 566 448
-------- -------- -------- --------
Total cost of revenue ...................................... 4,069 1,145 5,172 2,325

Gross margin (loss) ................................................ (3,819) (968) (4,839) (2,005)

Operating expenses:
Sales and marketing .............................................. 347 508 682 1,059
Research and product development ................................. 287 255 599 508
General and administrative ....................................... 445 528 916 1,312
(Gain) on disposal of assets ..................................... -- (1) -- (13)
Impairment of intangible assets .................................. -- -- 587 --
-------- -------- -------- --------
Total operating expenses ................................... 1,079 1,290 2,784 2,866
-------- -------- -------- --------
Loss from operations ............................................... (4,898) (2,258) (7,623) (4,871)

Other income (expense):
Interest income .................................................. 1 8 2 26
Interest expense ................................................. (50) (55) (89) (102)
Change in fair value of warrant liability ........................ 179 (41) 198 107
(Loss) on closure of subidiaries ................................. -- -- -- (499)
Other income/(expense) ........................................... (19) (78) 98 (59)
-------- -------- -------- --------
Loss before provision for income taxes ............................. (4,787) (2,424) (7,414) (5,398)
Income tax provision ............................................. -- -- -- --
-------- -------- -------- --------

Loss from continuing operations .................................... (4,787) (2,424) (7,414) (5,398)
Loss from discontinued operations .................................. (7) (20) (16) (66)
-------- -------- -------- --------
Net loss ........................................................... $ (4,794) $ (2,444) $ (7,430) $ (5,464)
======== ======== ======== ========

Loss per share from continuing operations - basic and diluted ...... (0.14) (0.12) (0.22) (0.31)
Loss per share from discontinued operations - basic and diluted .... (0.00) (0.00) (0.00) (0.00)
-------- -------- --------
Net loss per share applicable to common shareholders - basic and
diluted .......................................................... $ (0.14) $ (0.12) $ (0.22) $ (0.31)
======== ======== ======== ========

Weighted average common shares outstanding - basic and diluted ..... 35,399 19,685 33,063 19,460

The accompanying notes are an integral part of the consolidated financial
statements.

Page 4

LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

SIX MONTHS ENDED
JUNE 30,
2004 2003
--------- ---------

Cash flows from operating activities:
Net loss ............................................................. $ (7,430) $ (5,464)
Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization ...................................... 4,281 1,605
Change in fair value of warrant liability .......................... (198) (107)
Stock compensation expense ......................................... 121 15
Impairment of intangible assets .................................... 587 --
Provision for doubtful accounts .................................... (7) (52)
(Gain) on disposal of assets ....................................... -- (13)
Other .............................................................. -- 1
Changes in assets and liabilities, net of assets acquired and
liabilities assumed:
Trade accounts receivable and related party receivables .......... (29) 1,254
Assets and liabilities - discontinued operations ................. 44 623
Prepaid expenses and other assets ................................ 276 171
Accounts payable and accrued expenses ............................ 449 (498)
Deferred revenue ................................................. 212 (128)
--------- ---------
Net cash used in operating activities .......................... (1,694) (2,593)
Cash flows from investing activities:
Repayment of note receivable ......................................... -- 805
--------- ---------
Net cash provided by investing activities ...................... -- 805
Cash flows from financing activities:
Proceeds from issuance of common shares, net of issuance costs ....... 1,247 --
Proceeds from convertible redeemable preferred stock, net of cash held
in escrow of 1,387 ................................................. -- 2,143
Borrowings under credit facility, term loans, notes payable .......... 772 --
Repayments of term loans, credit facility and notes payable .......... (319) (513)
--------- ---------
Net cash provided by financing activities ...................... 1,700 1,630
Effect of exchange rate changes on cash ................................ 4 (2)
Net increase (decrease) in cash and cash equivalents ................... 10 (160)
Cash and cash equivalents:
Beginning of period .................................................. 19 199
--------- ---------
End of period ........................................................ $ 29 $ 39
========= =========

The accompanying notes are an integral part of the consolidated financial
statements.

Page 5

LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(IN THOUSANDS)

THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2004 2003 2004 2003
--------- --------- --------- ---------

Net loss ................................. $ (4,794) $ (2,444) $ (7,430) $ (5,464)
Other comprehensive income, net of tax:
Foreign currency translation adjustment 3 (68) 4 (2)
--------- --------- --------- ---------
Comprehensive loss ....................... $ (4,791) $ (2,512) $ (7,426) $ (5,466)
--------- --------- --------- ---------

The accompanying notes are an integral part of the consolidated financial
statements.

Page 6

LEVEL 8 SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(amounts in thousands, except per share data)
(unaudited)

NOTE 1. INTERIM FINANCIAL STATEMENTS

The accompanying financial statements are unaudited, and have been prepared
pursuant to the rules and regulations of the Securities and Exchange Commission
("SEC"). Certain information and note disclosures normally included in annual
financial statements prepared in accordance with generally accepted accounting
principles of the United States of America have been condensed or omitted
pursuant to those rules and regulations. Accordingly, these interim financial
statements should be read in conjunction with the audited financial statements
and notes thereto contained in the Level 8 Systems, Inc.'s (the "Company")
Annual Report on Form 10-K for the year ended December 31, 2003. The results of
operations for the interim periods shown in this report are not necessarily
indicative of results to be expected for other interim periods or for the full
fiscal year. In the opinion of management, the information contained herein
reflects all adjustments necessary for a fair statement of the interim results
of operations. All such adjustments are of a normal, recurring nature. Certain
reclassifications have been made to the prior year amounts to conform to the
current year presentation.

The year-end condensed balance sheet data was derived from audited financial
statements in accordance with the rules and regulations of the SEC, but does not
include all disclosures required for financial statements prepared in accordance
with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements include the accounts of the
Company and its subsidiaries. All of the Company's subsidiaries are wholly owned
for the periods presented.

LIQUIDITY

The accompanying financial statements have been prepared on a going concern
basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. The Company has incurred a loss of
$10,006 and $18,182 in the past two years and has experienced negative cash
flows from operations for each of the past three years. For the six months ended
June 30, 2004, the Company incurred a loss of $7,430 and had a working capital
deficiency of $7,835. The Company's future revenues are largely dependent on
acceptance of a newly developed and marketed product, Cicero, which has had
limited success in commercial markets to date. Accordingly, there is substantial
doubt that the Company can continue as a going concern. In order to address
these issues and to obtain adequate financing for the Company's operations for
the next twelve months, the Company is actively promoting and expanding its
Cicero related product line and continues to negotiate with customers that have
expressed an interest in the Cicero technology. The Company is experiencing
difficulty increasing sales revenue largely because of the inimitable nature of
the product as well as customer concerns about the financial viability of the
Company. The Company is attempting to solve the former problem by improving the
market's knowledge and understanding of Cicero through increased marketing and
leveraging its limited number of reference accounts. The Company is attempting
to address the financial concerns of potential customers by pursuing strategic
partnerships with companies that have significant financial resources although
the Company has not experienced significant success to date with this approach.
Additionally, the Company is seeking additional equity capital or other
strategic transactions in the near term to provide additional liquidity. There
can be no assurance that management will be successful in executing these
strategies as anticipated or in a timely manner or that increased revenues will
reduce further operating losses. If the Company is unable to significantly
increase cash flow or obtain additional financing, it will likely be unable to
generate sufficient capital to fund operations for the next twelve months and
may be required to pursue other means of financing that may not be on terms
favorable to the Company or its stockholders. These factors among others may
indicate that the Company will be unable to continue as a going concern for a
reasonable period of time.

Page 7

The financial statements presented herein do not include any adjustments
relating to the recoverability of assets and classification of liabilities that
might be necessary should the Company be unable to continue as a going concern.
As discussed in Notes 3 and 8, the Company recently completed a private
placement of its common stock wherein it raised $1,247 of new capital.
Management expects that it will be able to raise additional capital and to
continue to fund operations and also expects that increased revenues will reduce
its operating losses in future periods, however, there can be no assurance that
management's plan will be executed as anticipated.

USE OF ACCOUNTING ESTIMATES

The preparation of financial statements in conformity with accounting principals
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual amounts could differ from these estimates.

STOCK-BASED COMPENSATION

The Company has adopted the disclosure provisions of SFAS 123 and has applied
Accounting Principles Board Opinion No. 25 and related Interpretations in
accounting for its stock-based compensation plans. Had compensation cost for the
Company's stock option plan been determined based on the fair value at the grant
dates for awards under the plan consistent with the method required by SFAS No.
123, the Company's net loss and diluted net loss per common share would have
been the pro forma amounts indicated below.

THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2004 2003 2004 2003
------- ------- ------- -------

Net loss applicable to common stockholders .......... $(4,794) $(2,444) $(7,430) $(5,464)
Less: Total stock based employee compensation expense
under fair value based method for all awards, net of
related tax effects ................................. (133) (157) (461) (315)
------- ------- ------- -------
Pro forma loss applicable to common stockholders .... $(4,927) $(2,601) $(7,891) $(5,779)
======= ======= ======= =======
Loss per share:
Basic and diluted, as reported ...................... $ (0.14) $ (0.12) $ (0.22) $ (0.31)
Basic and diluted, pro forma ........................ $ (0.14) $ (0.13) $ (0.24) $ (0.33)

The fair value of the Company's stock-based awards to employees was estimated as
of the date of the grant using the Black-Scholes option-pricing model, using the
following weighted-average assumptions for the quarter and six months ended June
30, 2004 as follows:

Expected life (in years).................... 4.26 years
Expected volatility......................... 112.57%
Risk free interest rate..................... 4.00%
Expected dividend yield..................... 0%

The following table sets forth certain information as of June 30, 2004, about
shares of Common Stock outstanding and available for issuance under the
Company's existing equity compensation plans: the Level 8 Systems, Inc. 1997
Stock Option Incentive Plan, the 1995 Non-Qualified Option Plan and the Outside
Director Stock Option Plan. The Company's stockholders approved all of the
Company's Equity Compensation Plans.

Page 8

SHARES
----------
Outstanding on January 1, 2004 ........................... 5,625,878
Granted .................................................. 2,567,754
Exercised ................................................ (47,754)
Forfeited ................................................ (616,241)
----------
Outstanding on June 30, 2004 ............................. 7,529,637

Weighted average exercise price of outstanding options ... $ 1.70
Shares available for future grants on June 30, 2004 ...... 2,159,552

NOTE 2. RECENT ACCOUNTING PRONOUNCEMENTS

In January 2003, the FASB issued Interpretation No. 46 or FIN 46 "Consolidation
of Variable Interest Entities", an interpretation of Accounting Research
Bulletin No. 51, "Consolidated Financial Statements". In October 2003, the FASB
issued FASB Staff Position FIN 46-6, "Effective Date of FASB Interpretation No.
46, Consolidation of Variable Interest Entities" deferring the effective date
for applying the provisions of FIN 46 for public entities' interests in variable
interest entities or potential variable interest entities created before
February 1, 2003 for financial statements of interim or annual periods that end
after December 15, 2003. FIN 46 establishes accounting guidance for
consolidation of variable interest entities that function to support the
activities of the primary beneficiary. In December 2003, the FASB issued FIN 46
(revised December 2003), "Consolidation of Variable Interest Entities." This
revised interpretation is effective for all entities no later than the end of
the first reporting period that ends after March 15, 2004. The Company has no
investment in or contractual relationship or other business relationship with a
variable interest entity and therefore the adoption of this interpretation did
not have any impact on its consolidated financial position or results of
operations. However, if the Company enters into any such arrangement with a
variable interest entity in the future or an entity with which we have a
relationship is reconsidered based on guidance in FIN 46 to be a variable
interest entity, the Company's consolidated financial position or results of
operations might be materially impacted.

NOTE 3. ACQUISITIONS

In January 2004, the Company acquired substantially all of the assets and
certain liabilities of Critical Mass Mail, Inc., d/b/a Ensuredmail, a federally
certified encryption software company. Under the terms of the purchase
agreement, the Company issued 2,027,027 shares of common stock at a price of
$0.37. The total purchase price of the assets being acquired plus certain
liabilities assumed was $750, and has been accounted for by the purchase method
of accounting. The Company agreed to register the common stock for resale under
the Securities Act of 1933, as amended.

The purchase price was allocated to the assets acquired and liabilities assumed
based on the Company's estimates of fair value at the acquisition date. The
Company assessed the net realizable value of the Ensuredmail software technology
acquired and determined the purchase price exceeded the amounts allocated to the
software technology and liabilities acquired by approximately $587. This excess
of the purchase price over the fair values of the assets acquired less
liabilities assumed was allocated to goodwill and charged to the Statement of
Operations for the period ended March 31, 2004.

NOTE 4. SOFTWARE PRODUCT TECHNOLOGY

In accordance with FASB 86, "Accounting for the Costs of Computer Software to Be
Sold, Leased, or Otherwise Marketed", the Company completed an assessment of the
recoverability of the Cicero product technology, as of June 30, 2004. This
assessment was performed due to the Company's continued operating losses and the
limited software revenue generated by the Cicero technology over the past twelve
to eighteen months. Currently, the Company is in negotiations with customers to
purchase licenses, which would have a significant impact on the cash flows from
the Cicero technology and the Company. Since the negotiations have been in

Page 9

process for several months and expected completion of the transactions has been
delayed, the Company has reduced its cash flow projections. Historical cash
flows generated by the Cicero technology do not support the long-lived asset and
accordingly the Company has impaired the excess of the unamortized book value of
the technology in excess of the expected net realizable value as of June 30,
2004. This charge, in the amount of $2,844, has been recorded as software
amortization.

Also in accordance with FASB 86, "Accounting for the Costs of Computer Software
to Be Sold, Leased, or Otherwise Marketed", the Company completed an assessment
of the recoverability of the Ensuredmail product technology, as of June 30,
2004. This assessment was completed due to the Company's revised cash flow
projections from software revenue. These revised cash flow projections do not
support the long-lived asset and accordingly the Company has impaired the excess
of the unamortized book value of the technology in excess of the expected net
realizable value as of June 30, 2004. This charge, in the amount of $154, has
been recorded as software amortization.

NOTE 5. RESTRUCTURING CHARGES

At June 30, 2003, the Company's accrual for restructuring was $515, which was
primarily comprised of excess facility costs, which the Company believed
represented its remaining cash obligations for the restructuring changes. In
August 2003, the Company settled litigation relating to these excess facility
costs. Accordingly, the Company reversed the restructuring balance during the
third quarter of 2003. Under the terms of the settlement agreement, the Company
agreed to assign the note receivable from the sale of its Geneva software
technology to EM Software Solutions, Inc., with recourse equal to the unpaid
portion of the note receivable should the note obligor, EM Software Solutions,
Inc., default on future payments. The current unpaid principal portion of the
note receivable assigned is approximately $432 and matures December 2007. The
Company assessed the probability of liability under the recourse provisions
using a probability weighted cash flow analysis and has recognized a long-term
liability in the amount of $131.

NOTE 6. SHORT TERM CONVERTIBLE NOTES

In March 2004, the Company entered into a convertible loan agreement with Mark
and Carolyn Landis, who are related by marriage to Anthony Pizi, the Company's
Chairman and Chief Executive Officer, in the amount of $125. Under the terms of
the agreement, the loan bears interest at 1% per month, and is convertible into
446,429 shares of our common stock and warrants to purchase 446,429 shares of
the Company's common stock exercisable at $0.28. The warrants expire in three
years.

Also in March 2004, the Company entered into convertible loan agreements with
two other individual investors, each in the face amount of $50. Under the terms
of the agreement, each loan bears interest at 1% per month and is convertible
into 135,135 shares of our common stock and warrants to purchase 135,135 shares
of our common stock at $0.37 per share. The warrants expire in three years. In
May 2004, one of the note holders exercised their conversion right and converted
the debt obligation into 135,135 shares of common stock of the Company.

On April 12, 2004, the Company entered into a convertible promissory note with
Anthony Pizi, the Company's Chairman and Chief Executive Officer. The Note, in
the face amount of $100, bears interest at 1% per month and is convertible into
common stock of the Company at a conversion rate of $0.37 per share. In
addition, Mr. Pizi was granted 270,270 warrants to purchase the Company's common
stock at $0.37 per share. These warrants expire three years from the date of
grant.

In May 2004, the Company entered into convertible loans aggregating $185 from
several investors including a member of the Company's Board of Directors. Under
the terms of the agreements the loans bear interest at 1% per month and are
convertible into an aggregate of 578,125 shares of the Company's common stock
and warrants to purchase an aggregate of 578,125 shares of our common stock
exercisable at $0.32. The warrants expire in three years.

Page 10

In June 2004, the Company entered into a convertible promissory note with
Anthony Pizi, the Company's Chairman and Chief Executive Officer. The Note, in
the face amount of $112, bears interest at 1% per month and is convertible into
560,000 shares of the Company's common stock and warrants to purchase 560,000
shares of our common stock at $0.20 per share. Also in June 2004, Mr. Pizi
entered into a second convertible promissory note in the face amount of $15
which is convertible into 90,118 shares of the Company's common stock and
warrants to purchase 90,118 shares of the Company's common stock at $0.17 per
share. These warrants expire three years from the date of grant.

Also in June 2004, the Company entered into a convertible loan agreement with
Mark and Carolyn Landis, who are related by marriage to Anthony Pizi, the
Company's Chairman and Chief Executive Officer, in the amount of $125. Under the
terms of the agreement, the loan bears interest at 1% per month and is
convertible into 781,250 shares of our common stock and warrants to purchase
781,250 shares of the Company's common stock exercisable at $0.16. The warrants
expire in three years.

These obligations are included in Short-term debt on the Company's Balance Sheet
as of June 30, 2004.

NOTE 7. SENIOR CONVERTIBLE REDEEMABLE PREFERRED STOCK

On March 19, 2003, the Company completed a $3,500 private placement of Series D
Convertible Redeemable Preferred Stock ("Series D Preferred Stock"), convertible
at a conversion ratio of $0.32 per share of common stock into an aggregate of
11,031,250 shares of common stock. As part of the financing, the Company has
also issued warrants to purchase an aggregate of 4,158,780 shares of common
stock at an exercise price of $0.07 per share ("Series D-1 Warrants"). On
October 10, 2003, the Company, consistent with its obligations, also issued
warrants to purchase an aggregate of 1,665,720 shares of common stock at an
exercise price the lesser of $0.20 per share or market price at the time of
exercise ("Series D-2 Warrants"). The Series D-2 Warrants became exercisable on
November 1, 2003 because the Company failed to report $6,000 in gross revenues
for the nine-month period ended September 30, 2003. Both existing and new
investors participated in the financing. The Company also agreed to register the
common stock issuable upon conversion of the Series D Preferred Stock and
exercise of the warrants for resale under the Securities Act of 1933, as
amended. Under the terms of the financing agreement, a redemption event may
occur if any one person, entity or group shall control more than 35% of the
voting power of the Company's capital stock. The Company allocated the proceeds
received from the sale of the Series D Preferred Stock and warrants to the
preferred stock and detachable warrants on a relative fair value basis,
resulting in the allocation of $2,890 to the Series D Preferred Stock and $640
to the detachable warrants. Based upon the allocation of the proceeds, the
Company determined that the effective conversion price of the Series D Preferred
Stock was less than the fair value of the Company's common stock on the date of
issuance. The beneficial conversion feature was recorded as a discount on the
value of the Series D Preferred Stock and an increase in additional paid-in
capital. Because the Series D Preferred Stock was convertible immediately upon
issuance, the Company fully amortized such beneficial conversion feature on the
date of issuance.

As part of the financing, the Company and the lead investors have agreed to form
a joint venture to exploit the Cicero technology in the Asian market. The terms
of the agreement required that the Company deposit $1,000 of the gross proceeds
from the financing into escrow to fund the joint venture. The escrow agreement
allows for the immediate release of funds to cover organizational costs of the
joint venture. During the quarter ended March 31, 2003, $225 of escrowed funds
was released. Since the joint venture was not formed and operational on or by
July 17, 2003, the lead investors have the right, but not the obligation, to
require the Company to purchase $1,000 in liquidation value of the Series D
Preferred Stock at a 5% per annum premium, less their pro-rata share of
expenses. The Company and the lead investors have mutually agreed to extend the
escrow release provisions until September 30, 2004.

Another condition of the financing required the Company to place an additional
$1,000 of the gross proceeds into escrow, pending the execution of a definitive
agreement with Merrill Lynch providing for the sale of all rights, title and
interest to the Cicero technology. Since a transaction with Merrill Lynch for
the sale of Cicero was not consummated by May 18, 2003, the lead investors have

Page 11

the right, but not the obligation, to require the Company to purchase $1,000 in
liquidation value of the Series D Preferred Stock at a 5% per annum premium.
During the second quarter of 2003, $390 of escrowed funds was released. In
addition, the Company and the lead investors agreed to extend the escrow release
provisions until the end of July 2003 when all remaining escrow monies were
released to the Company.

NOTE 8. STOCKHOLDERS' EQUITY

As described in Note 3, Acquisitions, in January 2004, the Company acquired
substantially all of the assets and assumed certain liabilities of Critical Mass
Mail, Inc., d/b/a Ensuredmail, a federally certified encryption software
company. Under the terms of the purchase agreement, the Company issued 2,027,027
shares of common stock at a price of $0.37 per share. The total purchase price
of the assets acquired and liabilities assumed, was $750 and has been accounted
for by the purchase method of accounting.

Also in January 2004, and simultaneously with the asset purchase of Critical
Mass Mail, Inc., the Company completed a Securities Purchase Agreement with
several new investors as well as certain investors of Critical Mass Mail, Inc.,
wherein the Company raised $1,247 through the sale of 3,369,192 shares of common
stock at a price of $0.37 per share. As part of the financing, the Company has
also issued warrants to purchase 3,369,192 shares of the Company's common stock
at an exercise price of $0.37. The warrants expire three years from the date of
grant.

In October 2003, the Company entered into a Securities Purchase Agreement with
several investors wherein the Company agreed to sell 1,894,444 shares of its
common stock and issue 473,611 warrants to purchase the Company's common stock
at a price of $0.45 per share for a total of $853 in proceeds. This offering
closed on October 15, 2003. The warrants expire in three years from the date of
grant.

NOTE 9. INCOME TAXES

The Company accounts for income taxes in accordance with Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes." The Company's
effective tax rate differs from the statutory rate primarily due to the fact
that no income tax benefit was recorded for the net loss for the first and
second quarters of fiscal year 2004 or 2003. Because of the Company's recurring
losses, the deferred tax assets have been fully offset by a valuation allowance.

NOTE 10. LOSS PER SHARE

Basic loss per share is computed based upon the weighted average number of
common shares outstanding. Diluted (loss) per share is computed based upon the
weighted average number of common shares outstanding and any potentially
dilutive securities. Potentially dilutive securities outstanding during the
periods presented include stock options, warrants and preferred stock.

The following table sets forth the reconciliation of net loss to loss available
to common stockholders:

Page 12

THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2004 2003 2004 2003
-------- -------- ---------- --------

Net loss, as reported .................................... $ (4,794) $ (2,444) $ (7,430) $ (5,464)
Accretion of preferred stock ............................. -- -- -- 640
-------- -------- ---------- --------
Loss applicable to common stockholders, as adjusted ...... $ (4,794) $ (2,444) $ (7,430) $ (6,104)
======== ======== ========== ========

Basic and diluted loss per share:
Loss per share from continuing operations ................ $ (0.14) $ (0.12) $ (0.22) $ (0.31)
Loss per share from discontinued operations .............. -- -- -- --
-------- -------- ---------- --------
Net loss per share applicable to common shareholders ..... $ (0.14) $ (0.12) $ (0.22) $ (0.31)

Weighted common shares outstanding - basic and diluted ... 35,399 19,685 33,063 19,460

The following table sets forth the potential shares that are not included in the
diluted net loss per share calculation because to do so would be anti-dilutive
for the periods presented:

JUNE 30,
2004 2003
-------------- --------------
Stock options, common share equivalent 7,529,637 5,575,207
Warrants, common share equivalent 16,172,208 9,367,794
Preferred stock, common share equivalent 14,062,136 18,135,407
-------------- --------------
37,763,981 33,078,408
============== ==============

Accretion of the preferred stock arises as a result of the beneficial conversion
feature realized in the sale of preferred stock.

NOTE 11. SEGMENT INFORMATION AND GEOGRAPHIC INFORMATION

Management makes operating decisions and assesses performance of the Company's
operations based on the following reportable segments: Desktop Integration
segment and Messaging and Application Engineering segment.

The principal product in the Desktop Integration segment is Cicero. Cicero is a
business integration software product that maximizes end-user productivity,
streamlines business operations and integrates disparate systems and
applications.

The products that comprise the Messaging and Application Engineering segment is
Geneva Integration Broker and the encryption technology products, Email
Encryption Gateway, Software Development Kit (SDK), Digital Signature Module,
Business Desktop, and Personal Desktop.

Segment data includes a charge allocating all corporate-headquarters costs to
each of its operating segments based on each segment's proportionate share of
expenses. The Company evaluates the performance of its segments and allocates
resources to them based on earnings (loss) before interest and other
income/(expense), taxes, and in-process research and development.

While segment profitability should not be construed as a substitute for
operating income or a better indicator of liquidity than cash flows from
operating activities, which are determined in accordance with accounting
principles generally accepted in the United States of America, it is included
herein to provide additional information with respect to our ability to meet our
future debt service, capital expenditure and working capital requirements.
Segment profitability is not necessarily a measure of our ability to fund our
cash needs. The non-GAAP measures presented may not be comparable to similarly
titled measures reported by other companies.
The table below presents information about reported segments for the three
months and six months ended June 30, 2004 and 2003:

Page 13

MESSAGING AND
DESKTOP INTEGRATION APPLICATION ENGINEERING TOTAL
------------------- ----------------------- -------------------
June 30, 2004 June 30, 2004 June 30, 2004
------------------- ------------------- -------------------
Three Six Three Six Three Six
Months Months Months Months Months Months
Ended Ended Ended Ended Ended Ended
------- ------- ------- ------- ------- -------

Total revenue .................. $ 228 $ 305 $ 22 $ 28 $ 250 $ 333
Total cost of revenue .......... 3,900 4,958 169 214 4,069 5,172
------- ------- ------- ------- ------- -------
Gross margin (loss) ............ (3,672) (4,653) (147) (186) (3,819) (4,839)
------- ------- ------- ------- ------- -------
Total operating expenses ....... 971 1,959 108 238 1,079 2,197
Segment profitability (loss) .. $(4,643) $(6,612) $ (255) $ (424) $(4,898) $(7,036)
======= ======= ======= ======= ======= =======

MESSAGING AND
DESKTOP INTEGRATION APPLICATION ENGINEERING TOTAL
------------------- ----------------------- -------------------
June 30, 2003 June 30, 2003 June 30, 2003
------------------- ------------------- -------------------
Three Six Three Six Three Six
Months Months Months Months Months Months
Ended Ended Ended Ended Ended Ended
------- ------- ------- ------- ------- -------

Total revenue .................. $ 156 $ 275 $ 21 $ 45 $ 177 $ 320
Total cost of revenue .......... 1,114 2,252 31 73 1,145 2,325
------- ------- ------- ------- ------- -------
Gross margin (loss) ............ (958) (1,977) (10) (28) (968) (2,005)
------- ------- ------- ------- ------- -------
Total operating expenses ....... 1,236 2,736 55 143 1,291 2,879
Segment profitability (loss) ... $(2,194) $(4,713) $ (65) $ (171) $(2,259) $(4,884)
======= ======= ======= ======= ======= =======

A reconciliation of total segment operating expenses to total operating expenses
for the quarters ended June 30:

THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2004 2003 2004 2003
------- ------- ------- -------

Total segment operating expenses ........... $ 1,079 $ 1,291 $ 2,197 $ 2,879
(Gain) on disposal of assets ............... -- (1) -- (13)
Impairment of intangible assets ............ -- -- 587 --
------- ------- ------- -------
Total operating expenses ................... $ 1,079 $ 1,290 $ 2,784 $ 2,866
======= ======= ======= =======

A reconciliation of total segment (loss) to loss before provision for income
taxes for the quarters ended June 30:

THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2004 2003 2004 2003
------- ------- ------- -------

Total segment loss ......................... $(4,898) $(2,259) $(7,036) $(4,884)
Change in fair value of warrant
liability .................................. 179 (41) 198 107
Gain on disposal of assets ................. -- 1 -- 13
Impairment of intangible assets ............ -- -- (587) --
(Loss) on closure of subsidiaries .......... -- -- -- (499)
Interest and other income/(expense), net ... (68) (125) 11 (135)
------- ------- ------- -------
Total loss before income taxes ............. $(4,787) $(2,424) $(7,414) $(5,398)
======= ======= ======= =======

Page 14

The following table presents a summary of assets by segment:

SIX MONTHS ENDED JUNE 30,
2004 2003
-------- --------
Desktop Integration ..................... $ 21 $ 6,553
Messaging and Application Engineering ... -- --
-------- --------
Total assets ............................ $ 21 $ 6,553
======== ========

NOTE 12. CONTINGENCIES

Litigation. Various lawsuits and claims have been brought against the Company in
the normal course of business. In October 2003, the Company was served with a
summons and complaint in Superior Court of North Carolina regarding unpaid
invoices for services rendered to the Company by one of its vendors. The amount
in dispute is approximately $200 and is included in accounts payable. On May 12,
2004, this litigation was settled. Under the terms of the settlement agreement,
the Company agreed to pay a total of $189 plus interest over a twenty-month
period ending December 15, 2005. The current portion of this Note in the amount
of $117 is included in Short Term Debt on the accompanying balance sheet.

In March 2004, the Company was served with a summons and complaint in Superior
Court of North Carolina regarding a security deposit for a sublease in Virginia.
The amount in dispute is approximately $247. The Company disagrees with this
allegation although it has reserved for this contingency.

Under the indemnification clause of the Company's standard reseller agreements
and software license agreements, the Company agrees to defend the
reseller/licensee against third party claims asserting infringement by the
Company's products of certain intellectual property rights, which may include
patents, copyrights, trademarks or trade secrets, and to pay any judgments
entered on such claims against the reseller/licensee.

On August 5, 2004, the Company was notified that it was in default under an
existing lease agreement for office facilities in Princeton, New Jersey. The
amount of the default is approximately $65. The Company does not plan on curing
the default and will vacate the premises. The Company has estimated its
liability for future lease payments and recorded a charge in the amount of $98
in the accompanying Statement of Operations. The Company has secured
approximately 1,300 square feet of new office space located at 1433 State
Highway 33, Farmingdale, New Jersey under a short term lease.

Page 15

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

GENERAL INFORMATION

Level 8 Systems, Inc. is a global provider of business integration software that
enables organizations to integrate new and existing information and processes at
the desktop with Cicero. Business integration software addresses the emerging
need for a company's information systems to deliver enterprise-wide views of the
company's business information processes.

In addition to software products, Level 8 also provides technical support,
training and consulting services as part of its commitment to providing its
customers with industry-leading integration solutions. Level 8's consulting team
has in-depth experience in developing successful enterprise-class solutions as
well as valuable insight into the business information needs of customers in the
Global 5000. Level 8 offers services around its integration software products.

This discussion contains forward-looking statements relating to such matters as
anticipated financial performance, business prospects, technological
developments, new products, research and development activities, liquidity and
capital resources and similar matters. The Private Securities Litigation Reform
Act of 1995 provides a safe harbor for forward-looking statements. In order to
comply with the terms of the safe harbor, the Company notes that a variety of
factors could cause its actual results to differ materially from the anticipated
results or other expectations expressed in the Company's forward-looking
statements.

The Company's results of operations include the operations of the Company and
its subsidiaries. During 2002, the Company identified the assets of the Systems
Integration segment as being held for sale and thus a discontinued operation.
Accordingly, the assets and liabilities have been reclassified to assets held
for sale and the results of operations of that segment are now reclassified as
gain or loss from discontinued operations . Unless otherwise indicated, all
information is presented in thousands (`000s).

In 2004, the Company acquired Critical Mass Mail, Inc., d/b/a Ensuredmail, a
federally certified email encryption technology. Ensuredmail products are also
available as an integrated feature of Level 8's desktop application integration
solution, Cicero.

Page 16

RESULTS OF OPERATIONS

The table below presents information about reported segments for the three and
six months ended June 30, 2004 and 2003:

MESSAGING AND
DESKTOP INTEGRATION APPLICATION ENGINEERING TOTAL
------------------- ----------------------- -------------------
June 30, 2004 June 30, 2004 June 30, 2004
------------------- ------------------- -------------------
Three Six Three Six Three Six
Months Months Months Months Months Months
Ended Ended Ended Ended Ended Ended
------- ------- ------- ------- ------- -------

Total revenue .................. $ 228 $ 305 $ 22 $ 28 $ 250 $ 333
Total cost of revenue .......... 3,900 4,958 169 214 4,069 5,172
------- ------- ------- ------- ------- -------
Gross margin (loss) ............ (3,672) (4,653) (147) (186) (3,819) (4,839)
------- ------- ------- ------- ------- -------
Total operating expenses ....... 971 1,959 108 238 1,079 2,197
Segment profitability (loss) .. $(4,643) $(6,612) $ (255) $ (424) $(4,898) $(7,036)
======= ======= ======= ======= ======= =======

MESSAGING AND
DESKTOP INTEGRATION APPLICATION ENGINEERING TOTAL
------------------- ----------------------- -------------------
June 30, 2003 June 30, 2003 June 30, 2003
------------------- ------------------- -------------------
Three Six Three Six Three Six
Months Months Months Months Months Months
Ended Ended Ended Ended Ended Ended
------- ------- ------- ------- ------- -------

Total revenue .................. $ 156 $ 275 $ 21 $ 45 $ 177 $ 320
Total cost of revenue .......... 1,114 2,252 31 73 1,145 2,325
------- ------- ------- ------- ------- -------
Gross margin (loss) ............ (958) (1,977) (10) (28) (968) (2,005)
------- ------- ------- ------- ------- -------
Total operating expenses ....... 1,236 2,736 55 143 1,291 2,879
Segment profitability (loss) ... $(2,194) $(4,713) $ (65) $ (171) $(2,259) $(4,884)
======= ======= ======= ======= ======= =======

REVENUE AND GROSS MARGIN. The Company has three categories of revenue: software
products, maintenance, and services. Software products revenue is comprised
primarily of fees from licensing the Company's proprietary software products.
Maintenance revenue is comprised of fees for maintaining, supporting, and
providing periodic upgrades to the Company's software products. Services revenue
is comprised of fees for consulting and training services related to the
Company's software products.

The Company's revenues vary from quarter to quarter, due to market conditions,
the budgeting and purchasing cycles of customers and the effectiveness of the
Company's sales force. The Company typically does not have any material backlog
of unfilled software orders and product revenue in any quarter is substantially
dependent upon orders received in that quarter. Because the Company's operating
expenses are based on anticipated revenue levels and are relatively fixed over
the short term, variations in the timing of the recognition of revenue can cause
significant variations in operating results from quarter to quarter.
Fluctuations in operating results may result in volatility of the price of the
Company's common stock.

Total revenues increased 41% for the quarter ended June 30, 2004 from the same
period in 2003. The increase in revenues, was primarily the result of a pilot
program the Company is currently undergoing with one major company and an
initial installation with another major company. The Company believes that these
programs will lead to future deployment of its Cicero software. Despite these
two engagements, the Company continues to struggle for market acceptance. The
Company believes that there are a number of factors that contribute including
the relatively new category for the product, the environment for IT spending as
well as the fragility of the Company's financial condition. While the Company is
actively pursuing strategic partners to resell the product and the Company has
made significant progress on displaying the products capabilities to targeted
customers, there is no assurance that the Company will be successful in this

Page 17

endeavor. Gross margin/(losses) were (1,528)% for the quarter ended June 30,
2004 and (547)% for the quarter ended June 30, 2003.

SOFTWARE PRODUCTS. Software product revenue increased approximately 128% or $55
in 2004 from those results achieved in 2003 and is primarily attributable to two
active projects.

The gross margin (loss) on software products was (3,664)% for the quarter ended
June 30, 2004 and reflects the amortization and impairment of acquired software
not offset by revenues. In the similar quarter in 2003, gross margin (loss) on
software products was (1,865)%. Cost of software is composed primarily of
amortization of software product technology, amortization of capitalized
software costs for internally developed software and royalties to third parties,
and to a lesser extent, production and distribution costs. The increase in cost
of software was primarily due to the impairment to the Cicero technology of
approximately $2,844.

The Company expects to see significant increases in software sales related to
the Desktop Integration segment coupled with improving margins on software
products as Cicero gains acceptance in the marketplace. The Company's
expectations are based on its review of the sales cycle that has developed
around the Cicero product since being released by the Company, its review of the
pipeline of prospective customers and their anticipated capital expenditure
commitments and budgeting cycles, as well as the status of in-process proof of
concepts or beta sites with select corporations. The Messaging and Application
Engineering segment revenue is expected to increase marginally with on-line
sales of its products.

MAINTENANCE. Maintenance revenue for the quarter ended June 30, 2004 decreased
by approximately 13% or $11 as compared to the similar quarter for 2003. The
decline in overall maintenance revenues is primarily due to the termination of
one maintenance contract for the Geneva Integration Broker product within the
Messaging and Application Engineering segment.

The Desktop Integration segment accounted for approximately 96% of total
maintenance revenue for the quarter. The Messaging and Application Engineering
segment accounted for approximately 4% of total maintenance revenues. The
increase in the Desktop Integration maintenance as a percentage of the total is
primarily due to amortization of deferred maintenance revenues that resulted
from 2003 maintenance contracts.

Cost of maintenance is comprised of personnel costs and related overhead and the
cost of third-party contracts for the maintenance and support of the Company's
software products. Gross margin (loss) on maintenance products for the quarters
ended June 30, 2004 and June 30, 2003 was (29)%, and (23%), respectively.

The Desktop Integration segment had a negative gross margin on maintenance
revenues of 34% for the quarter ended June 30, 2004. The Messaging and
Application Engineering segment incurred no cost of maintenance resulting in a
gross margin of approximately 100% for the quarter.

Maintenance revenues are expected to increase in the Desktop Integration segment
and increase slightly in the Messaging and Application Engineering segment. The
cost of maintenance should remain constant for the Desktop Integration segment
and the Messaging and Application Engineering segment.

SERVICES. The Company recognized $79 services revenue for the quarter ended June
30, 2004. Services revenues are expected to increase for the Desktop Integration
segment as the Cicero product gains acceptance. The Messaging and Application
Engineering segment service revenues should be insignificant as the majority of
the relevant products are commercial off-the-shelf applications.

Cost of services primarily includes personnel and travel costs related to the
delivery of services. Services gross margins (losses) were (262)% for the
quarter ended June 30, 2004 and (294)% June 30, 2003.

SALES AND MARKETING. Sales and marketing expenses primarily include personnel
costs for salespeople, marketing personnel, travel and related overhead, as well
as trade show participation and promotional expenses. Sales and marketing

Page 18

expenses decreased by 32% or approximately $161 due to a reduction in the
Company's sales and marketing workforce and sales compensation structure.
Specifically, the Company reduced its headcount within sales and marketing by
two employees and changed the compensation structure to lower fixed costs and
increased variable success-based costs.

The Company's emphasis for the sales and marketing groups will be the Desktop
Integration segment.

RESEARCH AND DEVELOPMENT. Research and development expenses primarily include
personnel costs for product authors, product developers and product
documentation and related overhead. Research and development expense increased
by 13% or approximately $32 in the period ended June 30, 2004 as compared to the
same period in 2003. The increase in costs in 2004 reflects the additional costs
of encryption technology development personnel as well certain other costs being
reclassified for overhead purposes.

The Company intends to continue to make a significant investment in research and
development on its Cicero product while enhancing efficiencies in this area.

GENERAL AND ADMINISTRATIVE. General and administrative expenses consist of
personnel costs for the legal, financial, human resources, and administrative
staff, related overhead, and all non-allocable corporate costs of operating the
Company. General and administrative expenses for the quarter ended June 30, 2004
decreased by 16% or $83 over the same period in the prior year. The reason for
the decrease in costs is the reduction of IT service staff who have been
reclassified to cost of support and an overall reduction in the costs of
business fees.

General and administrative expenses are expected to decrease slightly going
forward as the Company continues to create certain efficiencies and
consolidations.

RESTRUCTURING. At June 30, 2003, the Company's accrual for restructuring was
$515, which was primarily comprised of excess facility costs and which the
Company believed represented its remaining cash obligations for the
restructuring changes. In August 2003, the Company settled litigation relating
to these excess facilities. Accordingly, the Company reversed the restructuring
balance during the fourth quarter of 2003. Under the terms of the settlement
agreement, the Company agreed to assign the note receivable from the sale of
Geneva to EM Software Solutions, Inc., with recourse equal to the unpaid portion
of the note receivable should the note obligor, EM Software Solutions, Inc.,
default on future payments. The current unpaid principal portion of the note
receivable assigned is approximately $432 and matures December 2007. The Company
assessed the probability of liability under the recourse provisions using a
probability weighted cash flow analysis and has recognized a long-term liability
in the amount of $131.

CHANGE IN FAIR VALUE OF WARRANT LIABILITY. The Company has recorded a warrant
liability for derivatives in accordance with EITF 00-19 for its common stock
warrants with redemption features outside the control of the Company. The fair
value of the warrants as of June 30, 2004 has been determined using valuation
techniques consistent with the valuation performed as of December 31, 2003 and
recorded as a warrant liability. As a result of the valuation, the Company has
recorded a reduction in the fair value of the warrant liability of $198.

PROVISION FOR TAXES. The Company's effective income tax rate for continuing
operations differs from the statutory rate primarily because an income tax
benefit was not recorded for the net loss incurred in the first and second
quarters of 2004 or 2003. Because of the Company's recurring losses, the
deferred tax assets have been fully offset by a valuation allowance.

SEGMENT PROFITABILITY. Segment profitability represents loss before income
taxes, interest and other income (expense), amortization of goodwill,
restructuring charges, gain (loss) on sale of assets, and impairment charges.
Segment profitability (loss) for the three and six months ended June 30, 2004
was approximately ($4,898) and ($7,036) respectively, as compared to ($2,259)
and ($4,884) respectively for the three and six months ended June 30, 2003. The
increase in the loss before income taxes, interest and other income and expense,
restructuring charges, and gain or loss on sale of assets is primarily
attributable to the impairment charges to the software technology taken in 2004.

Page 19

Segment profitability is not a measure of performance under accounting
principles generally accepted in the United States of America, and should not be
considered as a substitute for net income, cash flows from operating activities
and other income or cash flow statement data prepared in accordance with
accounting principles generally accepted in the United States of America, or as
a measure of profitability or liquidity. We have included information concerning
segment profitability as one measure of our cash flow and historical ability to
service debt and because we believe investors find this information useful.
Segment profitability as defined herein may not be comparable to similarly
titled measures reported by other companies.

IMPACT OF INFLATION. Inflation has not had a significant effect on the Company's
operating results during the periods presented.

LIQUIDITY AND CAPITAL RESOURCES

OPERATING AND INVESTING ACTIVITIES

The Company generated $10 of cash for the six months ended June 30, 2004.

Operating activities utilized approximately $1,700 of cash, which was primarily
comprised of the loss from operations of approximately $7,400, offset by
non-cash charges for depreciation and amortization of approximately $4,300, an
impairment of goodwill from the acquisition of the Ensuredmail technology in the
amount of approximately $600, offset by a non-cash adjustment to the fair value
of a warrant liability in the amount of $200. In addition, the Company's cash
increased by approximately $300 from the reduction in prepaid expenses and other
assets, approximately $200 for an increase in deferred revenues from maintenance
contracts and approximately $400 for the increase in accounts payable and
accrued expenses from vendors for services rendered.

The Company generated approximately $1,700 in cash during the first six months
of 2004 from financing activities from the proceeds of an additional round of
investment from several new investors totaling $1,200, an increase in net
short-term borrowings of $800, offset by repayments of the Company's short-term
debt in the amount of $300.

By comparison, in 2003, the Company utilized approximately $200 in cash during
the six months ended June 30, 2003.

Operating activities utilized approximately $2,600 of cash, which was primarily
comprised of the loss from operations of $5,500, offset by non-cash charges for
depreciation and amortization of approximately $1,600. In addition, the Company
generated $1,300 in cash through a reduction in accounts receivable, $600 in
cash through a reduction of assets and liabilities from discontinued operations
and used approximately $500 in fulfillment of its obligations to its creditors
through its accounts payable and other accrued liabilities. The significant
reduction in accounts receivable is the result of the reduction in overall
revenues in the Desktop Integration segment from the last quarter of 2002.

The Company generated approximately $1,600 in cash during the first six months
of 2003 from financing activities from the proceeds of the sale of Series D
Preferred Stock of approximately $3,500 offset by cash held in escrow of $1,400
and a reduction in the Company's short term debt in the amount of $513.

FINANCING ACTIVITIES

The Company funded its cash needs during the quarter ended June 30, 2004 with
cash on hand from March 31, 2004, with cash from operations and with the cash
realized from a private placement of its common stock and with the cash received
from short-term convertible note obligations.

In March 2004, the Company entered into a convertible loan agreement with Mark
and Carolyn Landis, who are related by marriage to Anthony Pizi, the Company's
Chairman and Chief Executive Officer, in the amount of $125. Under the terms of

Page 20

the agreement, the loan bears interest at 1% per month and is convertible into
446,429 shares of our common stock and warrants to purchase 446,429 shares of
our common stock exercisable at $0.28. The warrants expire in three years. The
Company also entered into convertible loan agreements with two other individual
investors, each in the face amount of $50. Under the terms of the agreement,
each loan is convertible into 135,135 shares of common stock and warrants to
purchase 135,135 shares of common stock at $0.37 per share. The warrants expire
in three years. In May 2004, one of the note holders elected to convert their
note into common stock of the Company.

In May 2004, the Company settled litigation with respect to a vendor services
complaint. The Company executed a Note payable in the amount of $189 plus
interest over a twenty month period ending December 15, 2005. This amount has
been reclassified from accounts payable in the accompanying balance sheet.

In April, 2004, the Company entered into a convertible promissory note with
Anthony Pizi, the Company's Chairman and Chief Executive Officer. The Note, in
the face amount of $100, bears interest at 1% per month and is convertible into
common stock of the Company at a conversion rate of $0.37 per share. In
addition, Mr. Pizi was granted 270,270 warrants to purchase the Company's common
stock at $0.37 per share. These warrants expire three years from the date of
grant.

In May 2004, the Company entered into convertible loans aggregating $185 from
several investors including a member of the Company's Board of Directors. Under
the terms of the agreements the loans bear interest at 1% per month and are
convertible into an aggregate of 578,125 shares of the Company's common stock
and warrants to purchase an aggregate of 578,125 shares of our common stock
exercisable at $0.32. The warrants expire in three years.

Also in May 2004, the Company pledged certain accounts receivables with an
investor for the face amount of $135 which bears interest at 1% per month and
warrants to purchase 211,214 shares of our common stock at a conversion rate of
$0.32 per share.

In June 2004, the Company entered into a convertible promissory note with
Anthony Pizi, the Company's Chairman and Chief Executive Officer. The Note, in
the face amount of $112, bears interest at 1% per month and is convertible into
560,000 shares of the Company's common stock and warrants to purchase 560,000
shares of our common stock at $0.20 per share. Also in June 2004, Mr. Pizi
entered into a second convertible promissory note in the face amount of $15
which is convertible into 90,118 shares of the Company's common stock and
warrants to purchase 90,118 shares of our common stock at $0.17 per share. These
warrants expire three years from the date of grant.

Also in June 2004, the Company entered into a convertible loan agreement with
Mark and Carolyn Landis, who are related by marriage to Anthony Pizi, the
Company's Chairman and Chief Executive Officer, in the amount of $125. Under the
terms of the agreement, the loan bears interest at 1% per month and is
convertible into 781,250 shares of our common stock and warrants to purchase
781,250 shares of our common stock exercisable at $0.16. The warrants expire in
three years.

The Company has a $1,971 term loan bearing interest at LIBOR plus 1%
(approximately 2.2% at June 30, 2004), interest on which is payable quarterly.
There are no financial covenants. On November 15, 2003, the Company reached an
agreement with Bank Hapoalim, the holder of the term loan and Liraz Systems Ltd.
("Liraz"), the guarantor of the term loan, to extend the maturity date of the
term loan until November 14, 2004. In consideration for the extension of the
guaranty, the Company issued 150,000 shares of our common stock to Liraz at the
time of the extension and subsequently issued an additional 150,000 shares on
March 31, 2004.

The Company has incurred losses of approximately $10,000 and $18,000 in the past
two years and has experienced negative cash flows from operations for each of
the past three years. For the quarter ended June 30, 2004 the Company incurred
an additional loss of approximately $7,300 and has a working capital deficiency
of approximately $7,700. The Company's future revenues are largely dependent on
acceptance of a newly developed and marketed product - Cicero. Accordingly,
there is substantial doubt that the Company can continue as a going concern. In
order to address these issues and to obtain adequate financing for the Company's

Page 21

operations for the next twelve months, the Company is actively promoting and
expanding its product line and has entered into preliminary sales negotiations
with customers that have begun the "proof of concept" stage. The Company is
experiencing difficulty increasing sales revenue largely because of the
inimitable nature of the product as well as customer concerns about the
financial viability of the Company. The Company is attempting to solve the
former problem by improving the market's knowledge and understanding of Cicero
through increased marketing and leveraging its limited number of reference
accounts. The Company is attempting to address the financial concerns of
potential customers by pursuing strategic partnerships with companies that have
significant financial resources although the Company has not experienced
significant success to date with this approach. Additionally, the Company is
seeking additional equity capital or other strategic transactions in the near
term to provide additional liquidity and it has recently completed a private
financing round wherein it raised approximately $1,200 of new funds from several
investors. There can be no assurance that management will be successful in
executing these strategies as anticipated or in a timely manner or that
increased revenues will reduce further operating losses. If the Company is
unable to significantly increase cash flow or obtain additional financing, it
will likely be unable to generate sufficient capital to fund operations for the
next twelve months and may be required to pursue other means of financing that
may not be on terms favorable to the Company or its stockholders.

The accompanying consolidated financial statements have been prepared on a going
concern basis, which contemplates the realization of assets and the satisfaction
of liabilities in the normal course of business. The financial statements
presented herein do not include any adjustments relating to the recoverability
of assets and classification of liabilities that might be necessary should Level
8 be unable to continue as a going concern.

OFF-BALANCE SHEET ARRANGEMENTS

The Company does not have any off-balance sheet arrangements. We have no
subsidiaries or other unconsolidated limited purpose entities, and we have not
guaranteed or otherwise supported the obligations of any other entity.

FORWARD-LOOKING AND CAUTIONARY STATEMENTS

Certain statements contained in this Quarterly Report may constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995 ("Reform Act"). We may also make forward-looking
statements in other reports filed with the Securities and Exchange Commission,
in materials delivered to shareholders, in press releases and in other public
statements. Forward-looking statements provide current expectations of future
events based on certain assumptions and include any statement that does not
directly relate to any historical or current fact. Words such as "anticipates,"
"believes," "expects," "estimates," "intends," "plans," "projects," and similar
expressions, may identify such forward looking statements. In accordance with
the Reform Act, set forth below are cautionary statements that accompany those
forward looking statements. Readers should carefully review these cautionary
statements as they identify certain important factors that could cause actual
results to differ materially from those in the forward-looking statements and
from historical trends.

The following cautionary statements are not exclusive and are in addition to
other factors discussed elsewhere in our filings with the Securities and
Exchange Commission and in materials incorporated therein by reference: there
may be a question as to our ability to operate as a going concern, our future
success depends on the market acceptance of the Cicero product and successful
execution of the new strategic direction; general economic or business
conditions may be less favorable than expected, resulting in, among other
things, lower than expected revenues; an unexpected revenue shortfall may
adversely affect our business because our expenses are largely fixed; our
quarterly operating results may vary significantly because we are not able to
accurately predict the amount and timing of individual sales and this may
adversely impact our stock price; trends in sales of our products and general
economic conditions may affect investors' expectations regarding our financial
performance and may adversely affect our stock price; our future results may
depend upon the continued growth and business use of the Internet; we may lose
market share and be required to reduce prices as a result of competition from
its existing competitors, other vendors and information systems departments of

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customers; we may not have the ability to recruit, train and retain qualified
personnel; rapid technological change could render the Company's products
obsolete; loss of any one of our major customers could adversely affect our
business; our products may contain undetected software errors, which could
adversely affect our business; because our technology is complex, we may be
exposed to liability claims; we may be unable to enforce or defend its ownership
and use of proprietary technology; because we are a technology company, our
common stock may be subject to erratic price fluctuations; and we may not have
sufficient liquidity and capital resources to meet changing business conditions.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As the Company has sold most of its European based business and has closed
several European sales offices, the majority of revenues are generated from US
sources. The Company expects that trend to continue for the next year. As such,
there is minimal foreign currency risk at present. Should the Company continue
to develop a reseller presence in Europe and Asia, that risk will be increased.

ITEM 4. CONTROLS AND PROCEDURES

Our management, under the supervision and with the participation of our Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the design and operation of the Company's disclosure controls and procedures
(as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)), as of the end of the
period covered by this report. Based upon that evaluation, the Chief Executive
Officer and the Chief Financial Officer concluded that the Company's disclosure
controls and procedures were effective of the end of the period covered by this
report. There have not been any changes in the Company's internal control over
financial reporting during the fiscal quarter to which this report relates that
have materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Various lawsuits and claims have been brought against the Company in
the normal course of business.

In October 2003, the Company was served with a summons and complaint in
Superior Court of North Carolina regarding unpaid invoices for services
rendered to the Company by one of its vendors. The amount in dispute is
approximately $200 and is included in accounts payable. On May 12,
2004, the Company settled this litigation. Under the terms of the
settlement agreement, the Company agreed to pay a total of $189 plus
interest over a twenty month period ending December 15, 2005.

In March 2004, the Company was served with a summons and complaint in
Superior Court of North Carolina regarding a security deposit for a
sublease in Virginia. The amount in dispute is approximately $247. The
Company disagrees with this allegation although it has reserved for
this contingency.

ITEM 2. CHANGES IN SECURITIES

In June 2004, the Company entered into a convertible promissory note
with Anthony Pizi, the Company's Chairman and Chief Executive Officer.
The Note, in the face amount of $112, bears interest at 1% per month
and is convertible into 560,000 shares of the Company's common stock
and warrants to purchase 560,000 shares of our common stock at $0.20
per share. Also in June 2004, Mr. Pizi entered into a second

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convertible promissory note in the face amount of $15 which is
convertible into 90,118 shares of the Company's common stock and
warrants to purchase 90,118 shares of our common stock at $0.17 per
share. These warrants expire three years from the date of grant.

Also in June 2004, the Company entered into a convertible loan
agreement with Mark and Carolyn Landis, who are related by marriage to
Anthony Pizi, the Company's Chairman and Chief Executive Officer, in
the amount of $125. Under the terms of the agreement, the loan is
convertible into 781,250 shares of our common stock and warrants to
purchase 781,250 shares of our common stock exercisable at $0.16. The
warrants expire in three years.

In May 2004, the Company entered into convertible loans aggregating
$185 from several investors including a member of the Company's Board
of Directors. Under the terms of the agreements the loans are
convertible into an aggregate of 578,125 shares of the Company's common
stock and warrants to purchase an aggregate of 578,125 shares of our
common stock exercisable at $0.32. The warrants expire in three years.

Also in May 2004, the Company pledged certain accounts receivables with
an investor for the face amount of $135 which bears interest at 1% per
month and warrants to purchase 211,214 shares of our common stock at a
conversion rate of $0.32 per share.

In April, 2004, the Company entered into a short term note payable with
Anthony Pizi, the Company's Chairman and Chief Executive Officer. The
Note, in the face amount of $100, bears interest at 1% per month and is
convertible into common stock of the Company at a conversion rate of
$0.37 per share. In addition, Mr. Pizi was granted 270,270 warrants to
purchase the Company's common stock at $0.37 per share. These warrants
expire three years from the date of grant.

In March 2004, the Company entered into a convertible loan agreement
with Mark and Carolyn Landis, who are related by marriage to Anthony
Pizi, the Company's Chairman and Chief Executive Officer, in the amount
of $125. Under the terms of the agreement, the loan is convertible into
446,429 shares of our common stock and warrants to purchase 446,429
shares of our common stock exercisable at $0.28. The warrants expire in
three years. We also entered into convertible loan agreements with two
other individual investors, each in the face amount of $50,000. Under
the terms of the agreement, each loan is convertible into 135,135
shares of our common stock and warrants to purchase 135,135 shares of
our common stock at $0.37 per share. The warrants expire in three
years. In May 2004, one of the note holders elected to convert their
note into common stock of the Company.

In January 2004, the Company acquired substantially all of the assets
and certain liabilities of Critical Mass Mail, Inc., d/b/a Ensuredmail,
a federally certified encryption software company. Under the terms of
the purchase agreement, the Company issued 2,027,027 shares of common
stock at a price of $0.37. The total purchase price of the assets and
certain liabilities being acquired was $750 and has been accounted for
by the purchase method of accounting. These shares were issued in
reliance upon the exemption from registration under Rule 506 of
Regulation D and on the exemption from registration provided by Section
4(2) of the Securities Act of 1933 for transactions by an issuer not
involving a public offering.

Also in January 2004, and simultaneously with the asset purchase of
Critical Mass Mail, Inc., the Company completed a Securities Purchase
Agreement with several new investors as well as certain investors of
Critical Mass Mail, Inc. wherein the Company raised $1,247 through the
sale of 3,369,192 shares of common stock at a price of $0.37 per share.
As part of the financing, the Company has also issued warrants to
purchase 3,369,192 shares of the Company's common stock at an exercise
price of $0.37. The warrants expire three years from the date of grant.
These shares were issued in reliance upon the exemption from
registration under Rule 506 of Regulation D and on the exemption from

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registration provided by Section 4(2) of the Securities Act of 1933 for
transactions by an issuer not involving a public offering.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

EXHIBIT
NO. DESCRIPTION

4.1 Form of Registration Rights Agreement issued to Purchasers of
Convertible Promissory Note (incorporated by reference to exhibit
4.2 to Level 8's 10-Q filed May 11, 2004)

4.2 Form of Stock Purchase Warrant issued to Purchasers of Convertible
Promissory Note (incorporated by reference to exhibit 4.4 to Level
8's 10-Q filed May 11, 2004)

10.1 Form of Securities Purchase Agreement dated May 2004 by and among
Level 8 Systems, Inc. and the Purchasers of Convertible Promissory
Note (incorporated by reference to exhibit 10.2 to Level 8's 10-Q
filed May 11, 2004)

10.2 Form of Convertible Promissory Note dated March 2004 by and among
Level 8 Systems, Inc. and the Purchasers of Convertible Promissory
Note (incorporated by reference to exhibit 10.3 to Level 8's 10-Q
filed May 11, 2004) 31.1 Certification of Chief Executive Officer
pursuant to Rule 13a-14(a) (filed herewith).

31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a)
(filed herewith).

32.1 Certification of Anthony C. Pizi and John P. Broderick pursuant to
18 USCss.1350, as adopted pursuant toss.906 of the Sarbanes-Oxley
Act of 2002 (filed herewith).

(b) Reports on Form 8-K

None

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.

LEVEL 8 SYSTEMS, INC.

By: /s/ Anthony C. Pizi
----------------------------
Anthony C. Pizi
Chief Executive Officer
Date: August 16, 2004

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